Taxing Lessons Case Summaries

Case — Step Transaction Doctrine

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TL Case Summ

THE QUESTION

When can separate steps in a multi-part transaction be collapsed into one?

THE DISPUTE

Taxpayer Says: Each of four transfers of property had an independent business purpose and they should not be collapsed into a single transaction.

Internal Revenue Service Says: The transfers were divided into four parts instead of one solely to avoid gift tax.

THE LAW

From From Holman v. Commissioner, 130 T.C. 170, 187 (2008), affd. ___ F.3d ___ (8th Cir., Apr. 7, 2010): Where an interrelated series of steps is taken pursuant to a plan to achieve an intended result, the tax consequences are to be determined not by viewing each step in isolation, but by considering all of them as an integrated whole.

From Senda v. Commissioner, 433 F.3d 1044, 1049 (8th Cir. 2006) (citing Commissioner v. Clark, supra at 738), affg. T.C. Memo. 2004-160: The step transaction doctrine is “well-established” and “expressly sanctioned” and may be applied in the area of gift tax where intra-family transactions often occur. Whether several transactions should be considered integrated steps of a single transaction is a question of fact.

From Estate of Cidulka v. Commissioner, T.C. Memo. 1996-149: It is appropriate to use the step transaction doctrine where the only reason that a single transaction was done as two or more separate transactions was to avoid gift tax.

THE CAUSE OF THE DISPUTE

Tax planning can involve multi-part transactions using legitimate strategies that are designed to reduce tax liability. For instance, an estate planning strategy may involve creating a partnership and later transferring interests in the partnership to family members as gifts.

The step transaction doctrine, a principle defined by court cases, “collapses” the separate steps into one, and applies tax law to the substance of the entire transaction, as opposed to each individual part.

In this case, the taxpayer created an LLC, with herself as the only member, and two trusts, for the benefit of family members. Three months later, she put $4.25 million into the LLC. Twelve days after that, she transferred her entire interest in the LLC to the trusts in four transactions that took place simultaneously. She treated two of the transactions (one to each trust) as gifts and reported them on a gift tax return. The remaining two transactions were treated as sales, with each trust giving her a secured promissory note. The sales were not reported as gifts.

The IRS says the purpose of using four transactions was to avoid gift tax, and that the two sales transactions were indirect gifts, subject to gift tax.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 28KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS. Nothing of tax-independent significance occurred in the moments between the gift transactions and the sale transactions. The gift transactions and the sale transactions were planned as a single transaction and the multiple steps were used solely for tax purposes. The taxpayer made a gift to each trust of her interest in the LLC to the extent the interest exceeds the value of the promissory note executed by the trust.
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